The foreign exchange (forex) market has a long and fascinating history that goes back much further than you might imagine. It’s fascinating to explore how it has evolved over the centuries and it highlights just how integral the concept of exchange is to human society.
If we’re going to take forex back to its first iteration, we need to travel back in time to Mesopotamia, when the concept of bartering – trading goods for other goods – was first introduced.
While we take forex to mean monetary currencies in this day and age, centuries ago currencies also referred to sought-after goods, such as salt, spices, fabrics and other materials. The arrival of the gold coin started to change the landscape though, which is when we began to see a more familiar trading arena develop.
The gold standard: the dawn of modern forex
In the 1800s, the gold standard was created as a way of benchmarking a country’s currency against the value of gold.
All this meant was that the government of the day would redeem paper money for its equivalent value in gold. This underpinned the global financial market in the 19th and early 20th centuries, because it provided a common, tangible asset to underpin the value of different currencies.
Ultimately it meant that when one country traded currencies with another, it could convert the currency it received into gold. At this point in history, forex trading was limited to big banking institutions and governments – the average person didn’t have an opportunity to engage in these kinds of financial transactions.
However, the gold standard didn’t last. The system stopped being used in the period between the first and second world wars. Britain, then a global economic powerhouse, stopped using the gold standard in 1931. The US followed just two years later.
From gold standard to the fiat system
What replaced the gold standard is what we still use today: the fiat system. Simply put, this means that the value of the world’s currencies is not fixed to a specific asset like gold. Instead, each currency’s value can fluctuate based on a variety of factors.
So, when we look at the forex market today, each currency’s value is derived based on its performance against other currencies in forex markets. This means that the market changes dynamically, supporting a more flexible global economy.
A really simple way to think of the fiat system is from the perspective of I Owe Yous (IOUs). So, when someone gives you a £5 note, that piece of paper is essentially an “IOU” for goods of that value. Of course, this is a very simplistic interpretation, but it’s a good way to bring forex markets back to basics.
This means that “fiat currency” is just another term for legal tender. In other words, a government in a specific country has specified that this currency will be accepted for payment of goods and services within its borders.
One of the major shifts to this way of trading came with the Bretton Woods agreement, which was signed in 1944. Under this agreement, other currencies around the world were “pegged” to the US dollar, making it the world’s reserve currency. The value of the US dollar, in return, was pegged to the value of gold.
This opened the doors to a system that provided a more stable way to trade currencies internationally. It also highlights how, even though the gold standard was no longer in use, the precious metal still played an important role in forex trading.
However, the Bretton Woods agreement was only short lived. In 1971, the system became unsustainable when there were concerns that the US didn’t have a high enough supply of gold to cover all the US dollars in circulation.
In other words, if everyone who held dollars had taken them to a US bank and converted them to gold, as they would have been entitled to do, there wouldn’t be enough gold to go around. Within two years, the Bretton Woods system had been abandoned and all global currencies were valued against one another.
The rise of electronic trading
We took another giant leap closer to the forex system we know today in the 1980s with the introduction of electronic currency trading. In fact, this period is perhaps the most important in modern forex trading’s history, because now countries and banks could trade with one another without having to physically pass money between them.
The main benefits of electronic trading were improved efficiency, quicker trades and a reduction in transaction costs. It also made forex trading more accessible and opened up new opportunities all over the world.
Electronic trading paved the way for the 24-hour dealer’s market that we now have access to via modern online trading platforms. But the retail forex trading market didn’t emerge until the 1990s. This was what really shifted the dynamics in the marketplace, because it meant that individual investors could make forex trades alongside banking institutions and governments.
Of course, technology has played a significant role in the accessibility of forex trading. From the introduction of the internet to the rise of smartphones and trading apps, we have seen the barriers to individual investors making forex trades decrease in recent decades.
Nowadays it’s possible to get access to instant forex funding and make trades from wherever you are, as long as you have a connected device.
The modern forex market
Today’s forex market not only allows investors to buy, sell, exchange and speculate on currencies. It also supports international currency conversions for trade settlements and investments.
In the current forex market, currencies are traded in pairs. The most liquid forex trading pairs in the world are the EUR/USD, USD/JPY and GBP/USD, although in theory currencies can be traded in many different combinations. In 2024, the global forex market was valued at $861 billion.
Its value is expected to increase considerably, with current predictions estimating it will reach $1,535 billion by 2033.
There are also multiple ways in which to trade on forex markets. The most common are FX swaps, spot transactions and outright forwards, while options and currency swaps are among the additional ways in which trades are executed.
Although the US dollar remains one of the dominant currencies in global forex trading, there are other players in the mix. The euro has become the world’s second most traded currency since its introduction in 1999, for instance, while the Chinese yuan has been growing in influence. As of 2024, it accounted for seven per cent of forex trades.
The changing complexion of the forex market
Two of the biggest shifts in forex trading that have contributed to its evolution are the introduction of electronic trading and the opportunity for individual investors to make trades. This means that forex trading evolved from being the preserve of financial institutions and governments to a market that anyone could get involved in.
This is reflected in the proliferation of electronic trading platforms that can give us access to forex markets from our phones and enable us to execute trades in seconds.
Over the years, three main types of forex market have evolved:
- Spot market: As the name suggests, this facilitates trades “on the spot” – or in the moment.
- Forward market: This is primarily used for hedging against currency fluctuations. It is a mechanism that allows two people – a buyer and a seller – to exchange currencies at an agreed rate on a specified future date. Crucially no currencies are actually exchanged during such trades, instead they are predicated on the values of the buyer’s and seller’s respective currencies.
- Futures market: Trades here are conducted in a similar way to on the forward market. However, the main difference is that futures trading happens on an exchange, which minimises the risk found in the forward market. The futures market is also regulated.
Looking ahead
The forex market has certainly evolved with the times and there is no reason to suspect that its evolution has finished.
There are many new advances on the horizon, from artificial intelligence (AI) and machine learning (ML) that are being incorporated into trading platforms to inform decisions and spot patterns, to the rise of cryptocurrencies and blockchain.
Blockchain could form part of this next evolution by allowing forex trading to further decentralise its record keeping by providing a reliable, permanent, accessible and secure way to record information about trades.
In addition, cryptocurrencies could provide the next frontier for forex trading, with some brokers already allowing crypto-to-crypto and even crypto-to-fiat trades. This is expected to have a significant impact on forex markets and is likely to form part of their next evolution.
While the integration of cryptocurrencies into traditional forex markets presents new opportunities for investors, it also comes with risks, particularly in relation to increased market volatility, uncertainty over the regulatory landscape and the possibility of market manipulation.
If you’re a forex investor, it is certainly an area to keep an eye on. It’s important that you continue to educate yourself about how forex markets work, what trades you can undertake and what the risks and opportunities are.